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Emerging Markets

Inside the Engine Room of EM Local Currency Debt

Helping to understand this often misunderstood asset class.

Nick Samouilhan, Ph.D., CFA, FRM, Solutions Strategist EMEA
Andrew Keirle, Portfolio Manager
Andrew Armstrong, Solutions Analyst

Executive Summary

  • With EM local currency debt being a complex asset class, it can prove challenging for investors, but there are potential rewards to be found.
  • Investment horizon matters.
  • When thinking about how best to allocate, managers should approach bond and currency selection as separate decisions, potentially with different objectives.

Emerging markets (EM) local currency (EMLC) debt is a complex asset class that can behave very differently over different time horizons, and this can make it challenging for investors to analyze the opportunity. In this paper, we’ll look at how investors might frame the opportunity more clearly, exploring ways to think about the risk and return drivers of this potentially rewarding asset class.

EM local currency debt is essentially a government bond investment, driven by currency and sovereign risk. It might be thought of as a higher‑yielding, higher‑risk extension of an investor’s global government bond allocation rather than solely part of an EM allocation.

The starting point for any analysis is recognizing that the total return to investors in EMLC debt consists of three
distinct drivers: coupon, price appreciation, and currency (FX). We’ll begin by looking at the impact of time horizon on EMLC investment outcomes and the role played by the different return drivers. We’ll then discuss some underlying dynamics of the return drivers, seeking to draw investment implications for asset owners and asset managers along the way. 

The Importance of Investment Time Horizon

It is tempting for investors to view EM local currency debt as a volatile asset class. This is understandable given that it seldom makes headlines except at times of market turbulence—often in the form of currency weakness. As a result, the blowups tend to eclipse the steady, consistent properties that make EM local currency debt worthwhile. Away from such short‑term noise, and in common with most asset classes, the level of realized volatility of the returns differs markedly, depending on the holding period. 

(Fig. 1) The Impact of Time Horizon
Long-term investors suffered less dispersion and volatility.
January 31, 2003, to October 31, 2018 

Past performance is not a reliable indicator of future performance.
Return distributions: Annualized 1- and 10-year returns for the J.P. Morgan GBI-EM Global Diversified Traded Index, rolled monthly. Volatility: Annualized standard deviation of 1-, 3-, and 10-year returns for the J.P. Morgan GBI-EM Global Diversified Traded Index, rolled monthly.
Source: J.P. Morgan Chase & Co.

Figure 1 shows historical EM local currency debt performance from two angles: the dispersion of returns and the volatility of those returns. The box and whisker chart show returns measured over one and 10-year holding periods, on a rolling monthly basis, since 2002. The distribution of these returns is substantially narrower for the 10‑year holding periods—a pattern that occurs to varying degrees in most asset classes, for different reasons. In the next section, we’ll discuss the factors behind the short‑term dispersion on the one hand and long‑term compression on the other.

Given that returns over 120‑month holding periods have been more stable than those over 12‑month periods, we would expect to see this pattern reflected in the volatility numbers. The bar chart shows the volatility of the rolling one and 10‑year periods already discussed and adds volatility for rolling three‑year periods. On an annualized basis, volatility over three and 10‑year periods has been significantly lower than it has for one‑year periods.

The holding period over which to examine the volatility of an investment is an important (and often incorrectly made) decision. Many investors use monthly return data, as a default, to estimate the volatility of an asset class. But this prism only makes sense if you expect to invest in and out of the asset class for periods of a month. Most investors tend to hold the investment for much longer horizons, typically years. This implies that the correct measure of the range of possible investment outcomes is best measured in terms of the volatility of longer holding periods, aligning the calculation period with the investment period. 

Opening Quote Coupons may drive long-term returns with minimal volatility. Closing Quote
— Andrew Armstrong, Solutions Analyst EMEA

Decomposing the Drivers of Performance

We have noted that longer holding periods are associated with narrower distributions of returns in EM local currency. The reason lies in the changing importance, over time, of the underlying return drivers of the asset class. The total return to investors in EM local currency debt consists of three related, but distinct, components:

Coupon: The regular coupons paid on the debt by the issuing sovereigns over time.

Price: Returns from price appreciation based on mark‑to‑market local interest rate movements.

Currency: The impact of currency fluctuations on the value of both the principal and the coupons, given that both are denominated in EM local currency rather than the investor’s base currency.

Figure 2 shows the proportionate contribution to total return at the asset class level of the three return drivers. As the chart makes clear, over short investment periods the largest driver of returns was the currency component. Over time, the largest driver became the coupon component. Interestingly, currency was the most volatile component, driven by FX movements, while coupon was very stable. As coupon payments accumulate over time, they account for a growing proportion of cumulative total return. By implication, as the less volatile component becomes dominant, superseding the more volatile component over longer and longer investment periods, the asset class must become less volatile. 

(Fig. 2) Drivers of Performance Over Time
Coupon became increasingly more important over time.
Contribution to return (USD), January 31, 2003, to October 31, 2018 

Past performance is not a reliable indicator of future performance.
Chart shows percentage of the squared returns for each component, over specified windows, for the J.P. Morgan GBI-EM Global Diversified Traded Index. Numbers may not sum due to rounding.
Source: J.P. Morgan Chase & Co. 

Opening Quote While investors cannot profitably isolate and remove all currency exposure, they can be selective about the FX risks they take. Closing Quote
— Nick Samouilhan Solutions Strategist, EMEA

For investors considering the asset class, it is important to establish their investment time frame in advance. Shorter‑term investments require a view on the direction of EM currencies and sufficient risk appetite to absorb short‑term FX volatility. Longer‑term investments acknowledge the growing importance and attractiveness of the coupon component.

From a manager selection perspective, the divergent behavior of the return drivers highlights the dangers of placing undue emphasis on short‑term performance. For example, looking at a sample of managers on a one‑year horizon, the winners will likely be those who spend a significant portion of their risk budget on active currency positioning to drive alpha. Over a longer time horizon, large currency bets are likely to be less important; the winners will be those who can collect coupon and generate idiosyncratic alpha via security selection.

Putting this a different way, the short‑term view gives a good picture of the interaction between a manager’s currency stance and the way the currency has moved, but it may reveal little about the manager’s bond selection skills. (This, as we explore in Analyzing Manager Style in EM Local Currency Debt, is why it’s important to identify what exposures managers are using to generate alpha.)  

(Fig. 3) The Asset Class and Its Components
Clear driver of risk has been from currencies.
December 31, 2002, to October 31, 2018 

Past performance is not a reliable indicator of future performance.
Component characteristics: J.P. Morgan GBI-EM Global Diversified Traded Index, based on monthly data. Return and volatility are annualized. Maximum drawdown is measured from peak to trough over the period from December 31, 2002, to October 31, 2018. Cumulative returns: components of the J.P. Morgan GBI-EM Global Diversified Traded Index (base = January 2003), as of October 31, 2018. Source: J.P. Morgan Chase & Co. 

Risk and Return Relationships

The historical paradox of EM local currency is that the lower‑risk components have delivered the highest return, while higher‑risk components have produced the lowest return. As shown in Figure 3, the driver of risk in EMLC has clearly been the FX component.

The coupon component has been, by far, the largest driver of long‑term returns for the asset class, with minimal volatility (given predictable, contractually agreed coupon flows) and no drawdowns. This is consistent with the investment‑grade credit quality of the index.

At the end of September 2018, the 19 sovereign issuers in the J.P. Morgan GBI‑EM Global Diversified Index had an average credit quality of BBB and a yield of about 6.6%. The index has a default rate of 0% since inception in June 2005, compared with an average of 2.35% for the J.P. Morgan Global High Yield Index over the same period (high yield defaults hit a high of 10.98% in November 2009).

Price appreciation returns from duration exposure reflect the general long‑term downward trend in EM interest rates, helped by structural reforms and a long‑term improvement in fundamentals. As shown in the volatility and drawdown numbers and the cumulative returns, passive duration exposure has had some ups and downs within the upward trend. 


Inside the Engine Room of EM Local Currency Debt

Important Information

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

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201902-751286 

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